What is Financial Leverage: Financial Leverage by Definition!
Financial leverage is the use of borrowed money to acquire additional assets with the expectation that the income or capital gained from the new asset will exceed the cost of borrowing. Financial leverage is also known as trading on equity. The financial leverage formula is the ratio of total debt to total assets. As the proportion of debt to assets increases, the amount of financial leverage also increases. Investors and business executives use financial leverage to turn small amounts into increased returns and profits. Assets need to be carefully balanced to avoid risks. Reckless executives can use the stockholder's trust and balance sheet to cause crippling losses. We will discuss the pros and cons of financial leverage below.
Here are some of the advantages of Financial Leverage.
1. Increased returns.
With a relatively small investment, financial leverage can yield high returns. Investors use financial leverage to turn small amounts into larger returns and profits. They do this by selling preferred stock and raise money to invest to add to shareholder earnings.
2. Credit rating improves.
When a company works effectively after taking financial leverage, it proves that the company can handle its business even when it is in debt. The ability to do this appeals to future financing, as it shows how it can successfully take on debt and succeed. Securing loans in the future will be an easy task, interest rates will be more attractive too.
3. Powerful access to capital.
Financial leverage amplifies the power of the capital you put to work. Leveraging finance for a short period of time can help the company achieve goals quicker or take care of short-term expenditure.
4. A rise in shareholder's equity.
Use of financial leverage can increase the company's stock. A leveraged company that earns 5 cents per stock in operating profit increases its equity by a larger amount, minus the interest expense.
5. Higher productivity.
Executives can accelerate productivity if it uses financial leverage to increase the size of its operation. It decreases the cost of each product and increases the profit margin in return. The customers benefit from this by having to pay less and gives an advantage to the company over other competitors.
Along with the benefits of financial leverage, there are some disadvantages.
1. Financial risk
There is always a risk when the company is in debt. The cost of interest will be present whether the company is making profits or no. The cost of interest expense is a factor to acknowledge before using leverage. When the debt cannot be paid off, the problem of defaulting a loan arises, which affects the company's credit score negatively.
2. More expensive.
Companies that have leveraged products pay higher interest rates to compensate investors for taking higher risks. With an increase in profit margins, there could be an increase in losses too. Using borrowed money can be very expensive.
3. Affects stock options issued to employees.
The unusually high increase in profits because of a large amount of leverage can increase the volatility of the company's stock price. Stock options for employees are affected as highly volatile stocks are more valuable and create a higher compensation expense compared to a less volatile share.
4. Highly risky for cyclical business.
There will be a fluctuation in profits and losses every year that increases the risk of bankruptcy over time. The amount of financial leverage is limited as lenders or investors will not indulge in lending more money to a company that has already borrowed a huge debt. It presents a high risk of outright bankruptcy if the cash flows fall lower than expected.
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